Description

Constar International (CNST) is maker of plastic (PET) containers for soft drinks, water, juices and food. It was spun out of Crown Holdings (CCK) in November, 2002. The stock price at yesterday’s close (7/23) and the price upon which my calculations are based was and is $8.53, which yields a market cap of $102M. It trades for ~5.2 x EV to trailing four quarter EBITDA of ~$89.4M and at 2x my estimate of 2003 FCF to equity. The stock is largely unknown to the street and I believe this is one reason it trades below the EV/EBITDA multiple of competitor Owens Illinois (~5.5x) and mothership CCK (~6.8x). However, what makes this story more interesting is the potential for growth in its “custom” business; I believe it could add significant upside.

2002 revenues of $704M were split 85/15 between low margin “traditional” bottles for soft drinks and water and higher margin “custom” containers. Thirty-seven percent of sales are Pepsi products (both soda and water) and are under contract through 2007. Even if I maintain the current multiple of 5.2x EV/EBITDA and multiply by my year-end EBITDA estimate of $101M, I get a stock price of $13.80. I’ll provide detail on the numbers and discuss catalysts, but first let me describe the technology that may provide upside.

The Technology:
Constar currently has a custom bottle technology called muli-layer oxbar that slows the transfer of oxygen from the outside of a plastic bottle to the product inside. This technology allows producers of drinks and food that are spoiled by oxygen to convert to plastic. Constar competes against Owens-Illinios, privately-held Graham, and Amcor for sales of containers using this technology.

However, a major step up in growth of glass to plastic conversions could be achieved if the technology could be improved to allow for the conversion of single-serving teas by the likes of Snapple and Arizona. The hold up is that the current technology does not allow tea makers to fill a plastic bottle with a hot liquid AND for the bottle to be the same size and shape as their current trademark bottles. The tea makers consider their bottle shapes to be an intricate part of their branding so they won’t convert if it means a new bottle shape. Yet, they want to convert to plastic because doing so would allow them to sell shrink-wrapped cases of single-serve tea at locations such as WalMart or CostCo. Today the weight of glass bottles puts a drag on such sales. (Women do most of the shopping and they do not want to handle a case of heavy, breakable bottles.)

As you might have guessed, Constar has an improved technology that allows for these conversions. It’s called mono-layer oxbar, it is under FDA review, and it could be approved in as little as six months. Management believes that it should be approved, but, of course, cannot promise. Handicapping FDA approval is outside my area of competence, but the prospects are good enough that potential customers are already running line trials or so management tells me. Should they win approval, it appears the company will at least have first mover advantage on a new market. Neither management or I include any upside from this technology in our projections.

The Numbers:
Management projects 15% growth in EBITDA in 2003 based on 3-5% growth in traditional revenues and 22-25% growth in custom. They say that most of the 2003 custom growth comes from one major applesauce brand glass-to-plastic conversion that is already signed. In contrast to management I am projecting lower growth in 2003: only 2.5% growth in traditional revenues due to the cold winter and now a wet spring and only 22% growth in custom. My top-line projections should yield 8% EBITDA growth in 2003 or $101M. (Management projects ~$107M) Enterprise value of $460M = $101M market cap plus $372M in debt less $14.5M in cash. Thus, EV to my year-end EBITDA is ~4.5x. I get a DCF value of ~$13.00 which incorporates revenue growth in the next three years of 2.5% in traditional and very low-DD in custom; out-years see only LDD growth for both lines; my WACC is 7.04%. Resin is ~50% of COGS, but is a pass-through to customers with a 30-day lag. Thus, fluctuations in the commodity’s price can cause revenue to decline even when volumes and/or real pricing are going up. My projections for growth are net of resin. (While OI and CCK are logical comparables their asbestos issues muddle the issue. Other container makers trade at higher multiples as did OI and CCK prior to their asbestos falls.)

Changes in SG&A, R&D and capital structure that occurred from going from a division of CCK to a public company have made comparisons of costs, operating earnings and net income difficult. The resin factor makes the top-line a constantly moving target. Thus in order to model, I started with 1) last year’s revenue of $704 and a contribution margin before depreciation of $115M, 2) the fact that the top-line was split 85/15 between traditional and custom, and 3) the fact that custom has twice the margins as traditional and then used the proceeding three items to solve for the individual contribution margins from traditional and custom. I multiplied those segment contributions by the growth rates described above (2.5% for traditional; 22% for custom), added a small amount for fixed cost absorption (per management) and arrived at a 2003 contribution margin of $126.3. From this I subtracted (again per management) depreciation of $57M, SG&A of $19.6M, R&D of $6M, and interest of $33.5M on debt of $372M; I taxed EBT at 40% and arrived at a net income of $5.7M; a share count of 12M then yields an EPS of $0.48. All numbers are rounded and I certainly expect to have to update as the year progresses. Capex this year should be $55M ($9M of which is maintenance, but $5M of that is a one-time IT project); I have WC up by $2M, though management projects WC flat. I project FCF to shareholders as defined on your site at $53.7M which in turn yields a forward P/FCF of 2x. (FCF = NI of $5.7M plus depreciation of $57M less $9M in maintenance capex = $53.7M.) Investments in new capacity are only made after a long-term commitment is made by a new or an existing customer.

My projected 2003 ROE is a disappointing 2.2% -- which is another reason why I offer the stock no multiple expansion in arriving at my price target. However, I believe over the next 12 to 18 months as the catalysts described below are met that returns will improve. Current debt/capital is 60%, debt/EBITDA is 4.1x, I estimate 2003 EBITDA/interest at 3x. It trades at 41% of book value.

Catalyst

First, the company must show stable growth in its traditional business. The cold winter and wet spring make management’s 2003 estimates for 3-5% growth in the traditional business difficult to make – as such I lowered my estimates. The weather has affected all players in the industry and thus the slow sales here are more easily looked through. An eventual string of normalized weather and/or easy comparisons in the first half of ’04 should prompt growth in this segment. (Another factor that pushes traditional volumes up is the success of Pepsi in general and their new products in particular. Pepsi typically introduces new products each spring/summer. Sometimes they sell well, sometimes not. I’m not modeling extra growth based on new products, but it is a potential catalyst nonetheless.)

Second, the company must show it can meet its own estimates for growth in custom. Management’s goal of 22-25% growth in custom revenues is a high bar. Meeting this goal will validate the prospects for future growth in custom and as importantly give the street confidence that this is a management that can both project and run their business. As noted I kept my ’03 custom growth estimate at the low-end of guidance (22%) and have modeled only 10-12% growth for the next three years. I believe in the prospects for growth in custom conversions (based on in-use technologies), but I myself need more clarity on just how large and how lumpy they will be. As these data points come through it will add the clarity the street needs – in either direction. I consider a short-term let down in this regard, particularly if it is only a new contract timing issue, to be a buying opportunity.

Third, returns must improve. Meeting the first and second goals should improve returns, cash flow and earnings.

CNST is a deep value pick that may take time to develop, but I believe the potential will eventually be realized. Finally, FDA approval and market acceptance of their new custom, mono-layer technology would add real fizz to the story.